The Chancellor's Deficit Reduction Plan Is a Risk to the Economic Recovery

03/12/2014 16:47 GMT
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Updated
02/02/2015 10:59 GMT

In his Autumn Statement on Wednesday, the Chancellor reaffirmed his plan to eliminate the fiscal deficit (public sector net borrowing) by 2018/19. He is also going to put the issue to a vote in parliament. He will undoubtedly win the vote, but if the next government chooses to follow this path it could be making a huge mistake.

The Chancellor's plan requires a significant step-up in the pace of deficit reduction in the next few years. Cyclically-adjusted net borrowing is actually planned to increase from 4.1 per cent of GDP in 2013/14 to 4.2 per cent in 2014/15, but George Osborne thinks it could then be cut to 0.5 per cent of GDP by 2017/18.

It is no coincidence that the economy has started to grow strongly in the last couple of years when the pace of deficit reduction has been slackened. Picking up the pace again would put the economic recovery at risk.

In the short-term at least, the economy is likely to continue to grow strongly thanks to the stimulus provided by lower oil prices. But, unless prices keep on falling, this effect will prove to be temporary.

Meanwhile, economists and financial markets are becoming increasingly worried about the global economy, and prospects for the euro zone look particularly grim in the short-term. In his statement, the Chancellor said 'warning lights are flashing over the global economy'. If external events hit demand in the UK and the next government continues to cut the deficit irrespectively, there is a big risk that economic growth will slip sharply, just as it did in 2011.

There are structural reasons to worry about the UK's economic recovery too.

The OBR expects UK exports to increase at an annual rate of 4.2 per cent between 2014 and 2019, despite worries about the economic outlook for Europe (which receives half of the UK's exports), the recent appreciation of sterling and the poor performance of the last three years (when exports have actually fallen in value terms),. It is also looking for the recent investment spending boom to be extended, with growth of 6.7 per cent a year over the next five years.

Even so, given the scale of cuts in the public sector, it can only make its growth forecast add up by assuming that consumer demand is boosted by households taking on more debt - and at an unprecedented pace. Extraordinarily, the OBR thinks that by 2019 the household sector will have a financial deficit twice as big as in 2007 and 2008 when the financial crisis hit. As result, the household debt-to-income ratio is forecast to rise beyond its pre-crisis peak to over 180 per cent.

This is pretty implausible. If the next government tries to follow the deficit reduction path set out in the Autumn Statement, it can only succeed in the short-term because the household sector takes on debt at a faster pace than it did before the financial crisis. But that risks a house price bubble and bust, followed by a recession and ultimately a new blow-out in the government deficit.

More likely, households will not take on as much debt as it expects. If the next Chancellor sticks to the plans set out today by George Osborne, the result will be weaker growth in 2016 and 2017, repeating the mistake of 2010 and the experience of 2011 and 2012.